How Investors Can Exploit Greed and Fear

By Tim Lee

There are many adages and sayings in the money management business, but one of my favorites comes from Warren Buffett: "Be fearful when others are greedy and greedy when others are fearful."

Mr. Buffett has made a fortune many times over using that logic. However, for most investors that sage advice is difficult to follow. Here, I'd like to offer some insight into how to do just that in 2012.

I recently read a research report on the cyclical nature of the stock market that ranked various industry groupings by past performance. The report highlighted the tendency of groups which have performed well over the past couple of years to perform poorly in the coming year, and vice versa.

I'll cut to the chase and focus on two groups: one of 2011's best performers and one of the year's worst performers. Based on their 2011 performance relative to other industry groups, trading companies were ranked in the top five. In contrast, asset managers were ranked toward the bottom for 2011 as well as for the past several years.

Where are others looking greedy?

The trading companies group is currently trading at a relatively high valuation, with the group's average P/E ratio sitting at over 30. Compare this with the S&P 500 index's trailing multiple of 14.5 and you can see that these companies have been valued quite richly by the market over the past year. This group includes firms which distribute products and provide MRO (Maintenance, Repair & Overhaul) services. Given the propensity of market rhythms to favor an industry group, and then throw the same group out of favor, it seems that these stocks have had their few fat years and may be ripe for taking profits.

Where are others looking fearful?

In contrast, the asset managers group has been beaten up with the rest of the financial sector over the past couple of years. It seems as though any stock in the financial sector has the hangover of the 2008 crisis and the specter of the European crisis to contend with before investors even examine a cash flow statement. However, unlike many of the large banks, or the mortgage finance sector, these firms have limited direct exposure to the residential real estate markets, and they have pretty consistent, if variable, revenue streams. This tone of fear around the sector, and the industry group's poor relative performance in 2011, suggests this could be a place for investors to look more closely. This is especially true if the U.S. economy continues to produce surprising growth, or if the U.S. markets show strength in 2012.

Conclusion

In general terms, market volatility seems unlikely to abate in the short term as headlines drive traders from "risk-on" to "risk-off" and back again. To quote another old market adage: "You'll never go broke taking profits." We believe it makes sense in today's environment to be conservative and take profits when the investments you've made have performed favorably. With that said, we continue to believe that finding the sectors and groups that have strong fundamental underpinnings and a favorable structural environment offers the best opportunities.

Maintaining the discipline to be selling when the markets seem to have no top, and buying when the future looks darkest, has historically produced the best investment returns. As always, we believe that the foundation of any successful investment strategy should be formed through careful and detailed planning, with the specifics of each individual's situation driving appropriate investment allocations.

Timothy R. Lee, CFP®, is a managing director and cofounder of Monument Wealth Management in Alexandria, Va., a full-service investment and wealth management firm. Monument Wealth Management is backed by LPL Financial, an independent broker-dealer and Registered Investment Advisor, member FINRA/SIPC. Monument Wealth Management has been featured in several national media sources over the past several years. Follow Tim and Monument Wealth Management on their blog Off The Wall, on Twitter at @MonumentWealth, and on their Facebook page.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for individuals. To determine which investment is appropriate, please consult your financial advisor prior to investing. All performance references are historical and are not a guarantee of future results. Stock investing involves risks, including loss of principal.

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